Damodaran on the ‘foolhardy versus rational’ value of goodwill

“There is no asset on a company’s balance sheet that wreaks more havoc on valuation and good sense than goodwill,” writes Prof. Aswath Damodaran (NYU Stern School of Business) in his blog. “The first problem with goodwill is that it sounds good, and when something sounds good, people feel the urge to pay for it. The second problem is that, notwithstanding claims to the contrary, it is not an asset but a plug variable that measures everything and nothing at the same time.”

Recent changes to the financial accounting standards related to valuing goodwill impairment have also created, “… jobs … for accountants & appraisers, since their services are now required both at the time of the acquisition (to reappraise the value of the existing assets) and each period thereafter (to assess target company values),” the professor adds. “As is the case with most accounting rules, the rules have [also] obscured the principles of what the changes were meant to accomplish: create more transparency for investors about acquisition costs and more accountability for bad acquisitions.”

A tongue-in-cheek proposal. In prior blog posts, Damodaran has noted that in about 55% of acquisitions, the stock price of the acquiring company will drop. If this price decline equals the market’s collective judgment of an overpayment, then “why not break goodwill down into two components: the market ‘correction’ can be called foolhardy goodwill and the rest can be rational goodwill,” the professor suggests. Thus, if an acquirer pays $12 billion for a company with an adjusted book value of $4 billion and sees its market cap drop by $3 billion on the announcement, then the balance sheet should show $3 billion in foolhardy goodwill and $5 billion in rational goodwill. With hindsight, both types may require impairment, but Damodaran would argue “that firms—their top managers and bankers—should be held much more accountable for failures on the former, because they chose to do the acquisition in the face of investor opposition.”